HOW TO STOP THE STRIKE
Can't We All Just Be Friends?
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Schuyler Moore, Esq.
Stroock & Stroock & Lavan LLP

I.  Introduction

II. Calculation of Residuals
     A. In General
     B. The Hot Issues
     C. Existing Problems

III. Potential Solution
     A. Reasoning
     B. Benefits to this Approach

IV. Conclusion

DISCLAIMER

See other *Articles* written by Schuyler Moore.
See *Books* written by Schuyler Moore.

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I. INTRODUCTION

II. CALCULATION OF RESIDUALS

A. IN GENERAL

Residuals are contingent payments based on a percentage of a film's gross revenue. The majority of residuals are paid directly to the guild members, but some payments are also made to the guild's health and pension benefit plans. Residuals are calculated in the following manner:

Residuals on theatrical films are only calculated based on video and television revenues, not theatrical revenues.

Residuals are always calculated based on all or a portion of gross receipts. Thus, they are payable regardless of whether the film company makes a profit. From the film company's perspective, this is, by far, the worst aspect of residuals.

For film companies that distribute their own videos (as opposed to sublicensing video rights), only 20% of video revenues are included in gross receipts as a deemed royalty.

B. THE HOT ISSUES

So here are some of the issues that people are fighting about:

(1). Video and DVD.

The guilds agreed to include only 20% of video revenues in gross receipts as a deemed royalty back in the early 80's when manufacturing costs were much higher and video revenues were much lower. In its infancy, video was analogized to merchandising, and it simply made sense to calculate gross revenue to the film company based on the sales margin of each unit. The only problem is that margin has now vastly increased, while the 20% royalty has not. Video and DVD have now grown to be the largest income source for theatrical films and are of key importance to the guilds (in particular because residuals do not apply to theatrical revenues for theatrical films). The guilds are just not likely to accept the 20% royalty theory any more.

(2). The Internet.

Notwithstanding the recent spate of Internet bankruptcies, in the not-so-distant future, video-on-demand over the Internet will create a huge new source of film revenue, which to a lesser or greater extent will cannibalize other revenue sources. There are several barriers to making this practical (particularly download speed, quality, and piracy fears), but these barriers are rapidly falling. The problem for the guilds is that the guild agreements divide the film world into theatrical, video, pay TV, and free T.V., and it is not clear just where Internet revenues (or any video-on-demand revenue for that matter) fall, if anywhere, under the current guild agreements. In my book, The Biz, The Basic
Business, Legal and Financial Aspects of the Film Industry http://www.theelites.com/elitebooks.htm#smoore, I suggested that the answer may be "nowhere," which triggered a quick invitation to lunch from the guilds, where they explained that they thought Internet revenues fell under every category that was subject to residuals (surprise). In the pending negotiations, the guilds simply cannot risk missing the boat on Internet and video-on-demand revenue, particularly when that revenue will cannibalize other income streams that are currently subject to residuals. Even if Internet revenues are included, it can be guaranteed with almost absolute certainty that film companies will argue that only 20% of Internet revenues should be included in gross receipts, because such Internet revenue is likely to slowly cannibalize video and DVD revenues, which are currently on a 20% royalty basis. Since there are no manufacturing costs for distribution over the Internet, the guilds are not going to roll over on this one.

(3). Allocations.

It is bad enough when films are sold to third parties in packages (particularly television sales), resulting in skewed allocations to lower residual or non-guild films, but to add insult to injury, most of the studios are now vertically integrated with television networks or cable companies, so they are selling to themselves. This practice has lead to a number of lawsuits by talent claiming that their participations were short-changed by low-ball inter-company sales, and the guilds are lining up with the same grievance for residuals.

(4). Discounts and Buy-Outs.

The guild agreements contain concessions intended to help once-struggling media, including discounts on residuals for programs made for basic and pay cable television, and low buy-outs on foreign residuals for television shows. With the huge growth in all three of these markets, the guilds are no longer in the mood to subsidize them.

C. EXISTING PROBLEMS

Even aside from these current issues on the negotiating table, the calculation of residuals is riddled with ambiguity, inconsistency, and confusion. For example, the guild agreements are not designed to address independent film companies that use sales agents to pre-sell rights to various foreign countries. The guild agreements are negotiated between the studios and the guilds, and no one at the table is particularly thinking about how the agreements apply to independent film companies. The current guild agreements thus fail to address many common business practices, leading to disputes between film companies and the guilds, such as:

(1). "At Source" Calculation.

The guilds take the position that residuals should generally be calculated "at source," i.e., based on the gross receipts of the lowest level subdistributor, including foreign subdistributors. This causes endless disputes about how the "at source" calculation is to be made, when it applies, and who is liable. For example, in the case of an "outright sale," residuals apply to the sale price, and are not calculated "at source." Unfortunately, the guild agreements do not define an "outright sale," so there are many disputes over this term.

(2). Video Royalties.

The guilds take the position that when a distributor licenses video rights to a third party (as opposed to the distributor undertaking video distribution itself), 100% of the payments received are included in gross receipts, as opposed to only 20% being included, as in the case of self-distribution. Some distributors have taken the position that only 20% of video royalties received from third parties should be included in calculating residuals.

(3). Minimum Guaranty.

When a film company receives a minimum guaranty from a distributor under a pre-sale agreement, the guilds take the position that the minimum guaranty should be allocated one-third to theatrical (which is not subject to residuals), one-third to video, and one-third to television. Distributors like to allocate a much higher percentage to theatrical.

(4). Greater of Calculation.

The guilds take the position that residuals must be calculated based on the greater of (a) the portion of a minimum guaranty allocated to video and television or (b) the gross receipts of the sub-distributor for the particular media (even if no overages are received by the film company). Film companies view this as an unfair one-way ratchet.

III. POTENTIAL SOLUTION

So, let me suggest one potential simple solution to all this chaos. Why not calculate residuals right up front as a percentage of a film's budget? The amount of residuals thus calculated could then be paid in installments (e.g., one-fourth per year for four years) to more or less track the result under the current approach for the payment of residuals (where residuals are due as revenues are received). Alternatively, the residuals could be paid all up front if the guilds would accept a reasonable discount for the time value of money and elimination of the risk of non-payment that is inherent in the installment approach.

A. REASONING

There is tremendous logic for tying residuals to a film's budget:

First, in the absence of knowing anything else, the best prediction of a film's gross receipts is based on its budget. In fact, almost all pre-sales and output agreements provide for payments based on a film's budget, so there is a direct correlation between the budget and receipts.

Secondly, residuals have been paid long enough that expected residuals can be calculated, on average, as a percentage of a film's budget. In fact, this is exactly what SAG does when SAG demands an advance bond to secure residuals.

All I am suggesting is that this should be the end of the process, rather than the beginning. Of course, historical averages will not match any particular film's exact revenue, but this brings me to the third and final logical argument: Why should residuals be tied to a film's revenues in the first place? The intent is just to provide extra compensation to the guild members, and it is just as logical to base this extra compensation on a film's budget as it is to base it on gross receipts. So what percentage of the budget should residuals be? The starting point should simply be the historical average of residuals to film budgets, which will differ for each guild. From there, it is simply a matter of arm wrestling as to whether the percentage should be higher or lower when the guild agreements come up for renewal. This will at least be an honest negotiation, as opposed to the artificial debate about what income streams should or should not be included or whether a 20% video royalty is appropriate. In other words, money is money, and the bottom line is how much money will residuals cost, not whether any particular income stream is or is not included.

B. BENEFITS OF THIS APPROACH

This suggested approach benefits everyone. The first and most obvious benefit is that it creates certainty as to how much residuals will be owed, and it eliminates all the current chaos, confusion, and arguments over the calculation of residuals. It completely eliminates the time consuming and expensive accounting and auditing process. It would also benefit everyone if residuals were paid right up front as part of a film's budget. This has an obvious benefit to the guilds, in that it provides for certainty of payment and accelerated cash flow (albeit subject to a reasonable discount for the time value of money and elimination of risk).

Counter-intuitively, up-front payments also benefit film companies for several reasons:

A film's budget would thus increase by the amount of residuals, and because pre-sales and output agreements almost always calculate the amount owed as a function of the budget, an increase to the budget will increase the amount the film is sold for. I know this seems odd, but this is the way the film world works.

By including residuals in the budget, it becomes possible to finance residuals using standard film financing techniques, such as bank financing, pre-sales, etc. It is typically far better to have this issue dealt with up front than to be caught owing residuals at a time when the film company does not have the cash to pay them; remember, residuals are calculated on gross, not net, receipts, so they apply even if a film is running at a loss.

As long as the up-front payment is discounted, the total amount of residuals owed is less than under the installment approach.

In all events, this suggested alternative is far better than the current lunacy. It would be a tragedy if the industry is shut down with strikes over issues as abstract as whether only 20% of Internet revenues should be included in gross receipts. This suggested alternative eliminates for all time the endless arguments that will otherwise occur as future media are developed.

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